Abstract

We study the stability of the banking system after a mortgage shock when a discretionary bailout policy is applied. Results suggest that the authority should be focused on preventing contagion. The decision over the appropriate policy depends upon the goal which the authority wants to pursue. Although it is very costly, the non-discriminatory policy prevails over the alternatives for most shock/bailout pairs. The medium-sized banks policy performs the worst and may be feasible only for a small number of low shock/low bailout probability pairs. We identify a threshold level after which the bailout costs decrease as the probability level increases.

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